When is carry not carry?(3)

Not long ago, we looked at how a converged standard on revenue recognition may make it tougher to compare and contrast target company financial statements, details of which can be found here.

But since then, we’ve learned of another hidden impact that the new revenue standard may have on the private funds community – one that’s giving CFOs some angst around how they record carried interest in the firm’s financial statement.

Today, most GPs record carry in the books as it’s achieved – so either when a portfolio company is exited, or when a fair value estimate indicates they’ve achieved the performance fee on paper.

The new revenue standard may change that. The rules say that any carry subject to clawback (which most funds provide for) isn’t actually firm revenue until it’s certain the cash will stay firmly in the GP’s pocket. In other words, carry isn’t actually carry until it becomes impossible for a single bad investment to result in the “revenue” being clawed back.

There’s a couple of significant impacts to consider here. First, the way carry is recorded in the firm’s financial statement may no longer sync with what LPs are told. The GP may have to wait until a fund is fully liquidated before recognizing carry at the firm level – but still report carry estimates to LPs in quarterly and annual performance reporting. Most managers will able to clarify any discrepancy with confused LPs with a few phone calls – but publicly-listed firms like Carlyle and KKR may have a tougher time explaining the situation to outside analysts. Some in the industry wonder if this will even lead analysts to begin considering non-GAAP financial metrics, in order to better track these firms’ quarterly earnings.

The other major impact could be around the accounting standards GPs follow when preparing their financial statements. A number of partnerships may choose to abandon US GAAP or International Financial Reporting Standards (IFRS) altogether, in order to realize carry dollars as they come in. Not doing so could impact the timing of partners’ remuneration, delaying payments until the fund is fully divested – a drawback in terms of talent retention. Since some banks and LPs require GPs to follow US GAAP or IFRS in order to do business, complications may arise here too.

As we said before, the new converged revenue standard ought to be a net benefit: a single set of accounting standards used worldwide makes it easier for people to scan and analyze financial statements across borders. But in practice, the change is likely to cause some growing pains – which may feel particularly acute to private fund managers.